Chapter 22, Problem 2P

1.

To determine

Journalize the cumulative effect of the retrospective adjustment of decrease in pretax income, on Company F’s prior year income that would be reported in 2020.

Explanation of Solution

Journal entry: Journal entry is a set of economic events which can be measured in monetary terms. These are recorded chronologically and systematically.

Debit and credit rules:

• Debit an increase in asset account, increase in expense account, decrease in liability account, and decrease in stockholders’ equity accounts.
• Credit decrease in asset account, increase in revenue account, increase in liability account, and increase in stockholders’ equity accounts.

Journalize the cumulative effect of the retrospective adjustment of decrease in pretax income, on Company F’s prior year income that would be reported in 2020.

Date		Account Titles and Explanations		Post. Ref.	Debit ($)	Credit ($)
		Inventory			60,000
			Retained Earnings			47,400
			Deferred Tax Liability			12,600
		(Record the cumulative effect of pretax income due to change from LIFO to FIFO)

Table (1)

Description:

• Inventory is an asset account. Since the cumulative difference has increased due to change from LIFO to FIFO inventory has increased, the asset account increased, and an increase in asset is debited.
• Deferred Tax Liability is a liability account. The obligation to pay taxes has increased on saved income taxes, due to increase in cumulative difference. The liability increased and an increase in liability is credited.
• Retained Earnings is an equity account. Since earnings increased due to increase in pretax income due to increase in cumulative difference out of the change from LIFO to FIFO, and an increase in equity is credited.

Working Notes:

Compute the deferred tax liability amount.

$\begin{array}{c}\text{Deferred tax liability = Pretax amount }\times \text{ Income tax rate}\\ \text{=}\left(\$42,000+\$18,000\right)\text{×21\%}\\ \text{=\$60,000×21\%}\\ \text{=\$12,600}\end{array}$

Compute retained earnings amount.

$\begin{array}{c}\text{Retained earnings = Pretax amount }\times \left(\text{1–Income tax rate}\right)\\ \text{=}\left(\$42,000+\$18,000\right)\text{×}\left(\text{1–21\%}\right)\\ \text{=\$60,000×79\%}\\ \text{=\$47,400}\end{array}$

2.

To determine

Prepare comparative income statements of Company F for the years 2019 and 2020.

Explanation of Solution

Income statement: The financial statement which reports revenues and expenses from business operations, and the result of those operations as net income or net loss for a particular time period is referred to as income statement.

Prepare comparative income statements of Company F for the years 2019 and 2020.

Company F
Income Statements (Partial)
	2020	2019 (As Adjusted)
Revenues	$230,000	$225,000
Cost of goods sold	(120,000)	(95,000)
Gross profit	110,000	130,000
Operating expenses	(40,000)	(32,000)
Income before taxes	70,000	98,000
Income tax expense	(14,700)	(20,580)
Net income	$55,300	$77,420
Earnings per share:
Net income	$5.53	$7.74

Table (2)

Working Notes:

Compute cost of goods sold for 2020.

$\begin{array}{c}\text{Cost of goods sold = }\left\{\begin{array}{l}\text{Revenues–}\\ \text{Operating expenses–}\\ \text{Reported income before taxes under LIFO}\end{array}\right\}\\ \text{=\$230,000–\$40,000–\$70,000}\\ \text{=\$110,000}\end{array}$

Compute expenses for 2019.

$\begin{array}{c}\text{Cost of goods sold = }\left\{\begin{array}{l}\text{Revenues–}\\ \text{Operating expenses–}\\ \text{Reported income before taxes under FIFO–}\\ \text{Decrease in cost of goods sold}\end{array}\right\}\\ \text{=\$225,000–\$32,000–\$80,000–\$18,000}\\ \text{=\$95,000}\end{array}$

Compute the income tax expense for 2020.

$\begin{array}{c}\text{Income tax expense = Reported income before taxes }\times \text{ Income tax rate}\\ \text{=\$70,000×21\%}\\ \text{=\$14,700}\end{array}$

Compute the income tax expense for 2019.

$\begin{array}{c}\text{Income tax expense = Adjusted income before taxes }\times \text{ Income tax rate}\\ \text{=\$98,000×21\%}\\ \text{=\$20,580}\end{array}$

Compute the earnings per share (EPS) for 2020.

$\begin{array}{c}\text{EPS = }\frac{\text{Net income – Preferred dividends}}{\text{Weighted average common shares outstanding}}\\ \text{=}\frac{\text{\$55,300–\$0}}{\text{10,000 shares}}\\ \text{=\$5}\text{.53}\end{array}$

Compute the earnings per share (EPS) for 2019.

$\begin{array}{c}\text{EPS = }\frac{\text{Net income – Preferred dividends}}{\text{Weighted average common shares outstanding}}\\ \text{=}\frac{\text{\$77,420–\$0}}{\text{10,000 shares}}\\ \text{=\$7}\text{.74}\end{array}$

3.

To determine

Prepare comparative statement of retained earnings of Company F for the years 2020 and 2019.

Explanation of Solution

Statement of retained earnings: This statement reports the beginning retained earnings and all the changes which led to ending retained earnings. Net income from income statement is added to and dividends is deducted from beginning retained earnings to arrive at the end result, ending retained earnings.

Prepare comparative statement of retained earnings of Company F for the years 2020 and 2019.

Company F
Statement of Retained Earnings
	2020	2019
Beginning unadjusted retained earnings	$252,800	$189,600
Plus: Adjustment for the cumulative effect on prior years of retrospectively applying the FIFO inventory method (net of taxes)	47,400	33,180
Adjusted retained earnings	300,200	222,780
Net income	55,300	77,420
Ending retained earnings	$355,500	$300,200

Table (3)

Working Notes:

Compute the beginning unadjusted retained earnings value for 2019.

$\begin{array}{c}\begin{array}{l}\text{Beginning unadjusted }\\ \text{retained earnings}\end{array}\}\text{ = }\left\{\begin{array}{l}\left(\text{Reported income before taxes prior to 2019}\right)\times \\ \left(\text{1–Income tax rate}\right)\end{array}\right\}\\ =\$240,000\text{×}\left(\text{1–21\%}\right)\\ \text{=\$189,600}\end{array}$

Compute the beginning unadjusted retained earnings value for 2020.

$\begin{array}{c}\begin{array}{l}\text{Beginning unadjusted }\\ \text{retained earnings}\end{array}\}\text{ = }\left\{\left(\begin{array}{l}\text{Retained earnings balance in 2019+}\\ \left(\begin{array}{l}\text{Reported income before taxes prior in 2019}\times \\ \left(\text{1–Income tax rate}\right)\end{array}\right)\end{array}\right)\right\}\\ =\$189,600+\left(\$80,000\text{×}\left(\text{1–21\%}\right)\right)\\ =\$189,600+63,200\\ \text{=\$252,800}\end{array}$

Compute the adjustment value for 2020.

$\begin{array}{c}\text{Retained earnings = Pretax amount }\times \left(\text{1–Income tax rate}\right)\\ \text{=}\left(\$42,000+\$18,000\right)\text{×}\left(\text{1–21\%}\right)\\ \text{=\$60,000×79\%}\\ \text{=\$47,400}\end{array}$

Compute the adjustment value for 2019.

$\begin{array}{c}\text{Adjustment value = Pretax amount }\times \left(\text{1–Income tax rate}\right)\\ \text{=\$42,000×}\left(\text{1–21\%}\right)\\ \text{=\$33,180}\end{array}$

4.

To determine

Prepare a note to comparative financial statements discussing the changes and effect of changes on income statements in 2019 and 2020.

Explanation of Solution

Note to financial statements: The company amended the method of inventory valuation and cost of goods sold from LIFO to FIFO, on January 1, 2020.     The new methods were adopted to record expenses, and adjust the financial statements retrospectively. The retrospective adjustment increased the retained earnings on January 1, 2019 by $33,180.

The following is the income statement for the years ended 2019:

Company F
Income Statements (Partial)
For the Years Ended December 31, 2019
	As Originally Reported under LIFO	As Adjusted to FIFO	Effect of Change
Revenues	$225,000	$225,000	$0
Cost of goods sold	(113,000)	(95,000)	18,000
Operating expenses	(32,000)	(32,000)	0
Income before income taxes	80,000	98,000	18,000
Income tax expense	(16,800)	(20,580)	(3,780)
Net income	$63,200	$77,420	$14,200
Earnings per share:
Net income	$6.32	$7.74	$1.42

Table (4)

Working Notes:

Compute cost of goods sold for original reporting under LIFO.

$\begin{array}{c}\text{Cost of goods sold = }\left\{\begin{array}{l}\text{Revenues–}\\ \text{Operating expenses–}\\ \text{Reported income before taxes under LIFO}\end{array}\right\}\\ \text{=\$225,000–\$32,000–\$80,000}\\ \text{=\$113,000}\end{array}$

Compute the income tax expense for original reporting under LIFO.

$\begin{array}{c}\text{Income tax expense = Adjusted income before taxes }\times \text{ Income tax rate}\\ \text{=\$80,000×21\%}\\ \text{=\$16,800}\end{array}$

Compute the earnings per share (EPS) for original reporting under LIFO.

$\begin{array}{c}\text{EPS = }\frac{\text{Net income – Preferred dividends}}{\text{Weighted average common shares outstanding}}\\ \text{=}\frac{\text{\$63,200–\$0}}{\text{10,000 shares}}\\ \text{=\$6}\text{.32}\end{array}$

The following is the income statement for the years ended 2020:

Company F
Income Statements (Partial)
For the Years Ended December 31, 2020
	As Computed under LIFO	As Reported under FIFO	Effect of Change
Revenues	$230,000	$230,000	$0
Cost of goods sold	(136,000)	(120,000)	16,000
Operating expenses	(40,000)	(40,000)	0
Income before income taxes	54,000	70,000	16,000
Income tax expense	(11,340)	(14,700)	(3,360)
Net income	$42,660	$55,300	$12,640
Earnings per share:
Net income	$4.27	$5.53	$1.26

Table (5)

Working Notes:

Compute cost of goods sold for as computed under LIFO.

$\begin{array}{c}\text{Cost of goods sold = }\left\{\begin{array}{l}\text{Cost of goods sold as reported under FIFO+}\\ \text{Excess of LIFO cost of goods sold over FIFO cpst of goods sold}\end{array}\right\}\\ \text{=\$120,000+\$16,000}\\ \text{=\$136,000}\end{array}$

Compute the income tax expense for as computed under LIFO.

$\begin{array}{c}\text{Income tax expense = Income before taxes }\times \text{ Income tax rate}\\ \text{=\$54,000×21\%}\\ \text{=\$11,340}\end{array}$

Compute the earnings per share (EPS) for as computed under LIFO.

$\begin{array}{c}\text{EPS = }\frac{\text{Net income – Preferred dividends}}{\text{Weighted average common shares outstanding}}\\ \text{=}\frac{\text{\$42,660–\$0}}{\text{10,000 shares}}\\ \text{=\$4}\text{.27}\end{array}$

5.

To determine

Explain the effect of 10% bonus of income on net income of 2020.

Explanation of Solution

Recognition of expense: If Company F pays 10% bonus on change in income of $60,000, the expense of $6,000 $\left(\$60,000\times 10\%\right)$ would be recognized by Company F as an expense in the year Company F adopts the change in accounting principle from LIFO to FIFO, in 2020. This is an indirect effect of a change in accounting principle because the prior year income is effected by change in elements of income like bonus. The indirect effect is accounted for by prospective method, and hence, the net income of 2018 and 2019 would not be affected.